Williamson’s Utility Maximisation Theory | Marginal Theories

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Williamson’s Utility Maximisation Theory!

Williamson has developed managerial-utility-maximisation theory as against profit maximisation. It is also known as the ‘managerial discretion theory’. In large modem firms, shareholders and managers are two separate groups. The shareholders want the maximum return on their investment and hence the maximisation of profits. The managers, on the other hand, have consideration other than profit maximisation in their utility functions. Thus the managers are interested not only in their own emoluments but also in the size of their staff and expenditure on them.

Thus Williamson’s theory is related to the maximisation of the manager’s utility which is a function of the expenditure on staff and emoluments and discretionary funds. “To the extent that pressure from the capital market and competition in the product market is imperfect, the manager, therefore, has discretion to pursue goals other than profits.”

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The managers derive utility from a wide range of variables. For this Williamson introduces the concept of expense preferences. It means “that managers get satisfaction from using some of the firm’s potential profits for unnecessary spending on items from which they personally benefit.”

To pursue his goal of utility maximisation, the manager directs the firm’s resources in three ways:

1. The manager desires to expand his staff and to increase their salaries. “More staff is valued because they lead to the manager getting more salary, more prestige and more security.” Such staff expenditures by managers are denoted by S.

2. To maximise his utility, the manager indulges in “featherbedding” such as pretty secretaries, company cars, too many company phones, ‘perks’ for employees, etc. Such expenditures are charac­terised as ‘management slack’, M by Williamson.

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3. The manager likes to set up “discretionary funds” for making investments to advance or pro­mote company projects that are close to his heart. Discretionary profits or investments D are what remains with the manager after paying taxes and dividends to shareholders in order to retain an effective control of the firm.

Thus the manager’s utility function is U = f (S, M, D)

where U is the utility function, S is the staff expenditure, M is the management slack and D the discre­tionary investments. These decision variables (S, M, D) yield positive utility and the firm will always choose their values subject to the constraint, S ≥0≥M0, D≥0. Williamson assumes that the law of diminishing marginal utility applies so that when additions are made to each of S, M and D, they yield smaller increments of utility to the manager.

Further, Williamson regards price (P) as a function of output (X), expenditure on staff (S), and the state of environment which he calls ‘a demand shift parameter’ (E), so that P = f (X, S, E).

This relationship is subject to the following constraints:

(a) The demand function is assumed to be negatively sloping: ∂P/ ∂X<0; {b) staff expenditures help increase the demand for the firms product: ∂P/ ∂S>0; and (c) increases in the demand shift param­eter E, tend to raise demand: ∂P/ ∂E>0.

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These relationships reveal that the demand for X is negatively related to P, but is positively related to S and E. When the demand increases, the output and expenditure on staff will also increase which will push the costs of the firm, and consequently the price will rise, and vice versa.

In order to formalise his model, Williamson introduces four different types of profits: actual, reported, minimum required and discretionary profits. Denoting R = revenue, C = total production costs and T = taxes, then actual profits πA =R-C-S

If the amounts of managerial slack or emoluments (M) are deducted from the actual profits, we get reported profits.

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πR= π A= M =R –C –S –M

The minimum required profits, π0, are the lowest level of profits after paying taxes which the shareholders must receive in order to hold shares of the firm.

Since discretionary profits (D) are what remains with the manager after paying taxes and divi­dends to shareholders, therefore,

D = πR – π0 – T

To explain Williamson’s utility maximisation model diagrammatically, it is assumed for the sake of simplicity that U=f (S, D) so that discretionary profits (D) are measured along the vertical axis and staff expenditures (5) on the hori­zontal axis in Figure 3.

FC is the feasibility curve show­ing the combinations of D and S available to the man­ager. It is also known as the profit-staff curve. UU1 and UU2 are the indifference curves of the manager which show the combination of D and S. To begin, as we move along the profit-staff curve from point F upwards, both profits and staff expenditures increase O till point P is reached. P is the profit maximisation point for the firm where SP is the maximum profit levels when OS staff expenditures are incurred.

But the equilibrium of the firm takes place when the manager chooses the tangency point M where his highest possible utility function UU2and the feasibility curve FC touch each other. Here the manager’s utility is maximised. The discretionary profits OD (=S1M) are less than the profit maximisation profits SP.

But the staff emoluments OS are maximised. However, Williamson points out that factors like taxes, changes in business conditions, etc. by affecting the feasibility curve can shift the optimum tangency point, like M in the Figure. Similarly, factors like changes in staff, emoluments, profits of stockholders, etc. by changing the shape of the utility function will shift the optimum position.

Critical Appraisal:

Williamson has supported his utility-maximisation hypothesis by citing a number of evidences which are generally consistent with his model. Thus his theory is empirically sound as compared with other managerial theories.

This model is also superior to Baumol’s sales-maximisation model because it also explains the facts involved in Baumol’s theory. Williamson does not treat sales maximisation as a single criterion like Baumol but as a means of the manager for increasing his staff and emoluments. This approach is rather more realistic.

Further, in Williamson’s model output is higher, and price and profits are lower than in the profit maximisation model. Silbertson has shown that Williamson’s model preserves the results of the normal profit-maximisation model in conditions of pure or perfect competition.

Weaknesses:

But there are some conceptual weaknesses of this model:

1. He does not clarify the basis of the derivation of his feasibility curve. In particular, he fails to indicate the constraint in the profit-staff relation, as shown by the shape of the feasibility curve.

2. He lumps together staff and manager’s emoluments in the utility curve. This mixing up of non- pecuniary and pecuniary benefits of the manager makes the utility function ambiguous. But these diffi­culties can be overcome by introducing a three-dimensional diagram. But it will make the analysis more complex.

3. This theory does not deal with oligopolistic interdependence and of oligopolistic rivalry.

4. According to Hawkins, most economists are reluctant to pursue Williamson’s utility-maximisation theory “due to the knowledge that so many factors (e.g., profit, sales, output, growth, number of staff and expenditure on plush offices and cars) are likely to give utility to people in industry that they shall end up with a model incapable of yielding any definite results.”